New American Socialism
No one knows what to call it...
That's part of the problem. It's difficult to criticize something that doesn't yet have a
proper name.
You can't just call our economic system "socialism." It's not. There's a profit motive
and private ownership of nearly all assets. Socialism has neither of these. Besides,
far too many people have become far too rich in our system to simply label it
"socialism."
If you have ever traveled to an actual socialist country â&#x20AC;&#x201C; with a power grid that never
works, little public sanitation, petty graft at every turn, and endemic, horrifying
poverty â&#x20AC;&#x201C; you realize our system and real socialism aren't the same at all.
Our system isn't truly capitalism either, though. The State intervenes in almost every
industry, often in a big and expensive way. With government at all levels making up
more than 40% of GDP, it's fair to say we live in a State-dominated society.
And we share other, disturbing similarities with typical socialist states. Not all of them
are economic. The most frightening similarity between the U.S. and classic
totalitarian socialist States is the mutual investment in and appreciation of violent
coercion. The U.S. has a huge standing army â&#x20AC;&#x201C; by far the most powerful in the world.
It fights aggressive foreign wars.
And it fights violent domestic wars: U.S. prisons are bulging with a large percentage
of the population. But the overwhelming majority of U.S. prisoners has never
committed a violent crime.

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Most of my readers probably aren't familiar with this violent side of America's culture.
It's the poor who suffer the most from these aspects of American life. It is their
children who are sent to foreign wars. It is their children who get sent to prison.
Likewise, as with all socialist experiments, it is the poor who suffer the worst
economic outcomes, too. It is their cash savings that get wiped out by inflation. It is
their jobs that disappear when regulations reduce capital investment or government
debt crowds out private capital in the markets.
If the poor knew the first thing about economics, they wouldn't keep voting for
socialist politicians and their programs. Alas, they don't even know the basics.
The poor in America, like the poor everywhere, still believe you can rob Peter to pay
Paul. They still believe their "leaders" are trying to serve their best interests. It is a
sad hoax. What has really happened is clear: Bamboozling the poor has become a
way of life for American politicians. And the poor's willingness – even eagerness – to
embrace the resulting economic slavery is the linchpin of our system.
But it's not only the poor who have become addicted to the system. Businessmen,
like Warren Buffett, embrace it too – despite its limitations and taxes. Buffett calls it
the "American System." He says it's the greatest system for creating wealth the

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world has ever seen.
We're not so sure.
Yes, it certainly makes it easy for big businessmen like Buffett to become wealthy.
But those same benefits don't accrue to the society at large. For example... even
though the value of America's production has soared over the last 40 years and asset
prices have risen considerably, our debts have grown even more.
When you adjust for debt and inflation, you discover America hasn't gotten richer at
all. Yes, we have become more affluent. And yes, some individuals have gotten vastly
richer. But taken as a whole, when you add back the debts we've racked up, the
country hasn't gotten richer at all. Since the end of the gold standard in 1971, real
after-tax wages, per capita, stagnated. On average, we haven't gotten any richer at
all in 40 years.

What happened over the last 40 years?
Why did so many people rush so eagerly into debt? Why did they borrow more and
more to buy the same things at ever-higher prices â&#x20AC;&#x201C; again, and again, and again?
And why do people in America continue to work, day after day, for jobs that offer no
opportunity and declining real wages? Most important, how did a few people end up
getting so rich from this merry-go-round economic system that never takes us
anywhere?
To answer this question, we need only answer one core question: Who benefits?
Whose wealth and power increases with inflation? Whose stature in society grows

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alongside the government? Who profits from increased spending on wars, prisons,
and social programs that are doomed to fail? And most of all... who profits from an
explosion in debt?
A certain class of people has the power to not only protect itself from these policies
but to profit as well. These people have used the last 40 years to produce massive
amounts of paper wealth. And they are now desperately trying to convert those
paper accounts into real wealth, which explains the exploding price of farmland and
precious metals.
This explosion of wealth at the top of the "food chain" is the main feature of what I
call New American Socialism. It's a system fueled by paper money, the constant
expansion of debt, and a kind of corruption that's hard to police because it occurs
within the boundaries of the law.
Like the European and totalitarian socialism of the last 100 years, New American
Socialism harnesses the power of the State to grow and maintain production. Like in
traditional socialism, the poor pay the costs of New American Socialism. But unlike
socialist systems of the past, this new American version has one critical
improvement...
In the New American Socialism, the power of the system produces private profits. In
this way, it provides a huge incentive to entrepreneurs and politicians to work
together on behalf of the system. This is what keeps the system going. This is what
keeps it from collapsing upon itself. And this, unfortunately, is why the imbalances in
the world economy will continue to grow until the entire global monetary system
itself implodes.
In this month's issue, I detail two investments I want you to make now... These steps
take advantage of the corruption inherent in the New American Socialism, and as I'll
explain, they will protect your portfolio from the imminent meltdown in credit
markets...

How New American Socialism Started
New American Socialism began with the policies of President Franklin Delano
Roosevelt. In 1933, FDR seized all the privately held gold in the U.S. and began
creating the massive government programs necessary to implement socialism. To
give you some idea of how much the federal government grew during FDR's reign,
remember federal spending made up 3% of GDP in 1930 â&#x20AC;&#x201C; a level that had been
fairly consistent for most of America's history. Almost immediately after his election,
he tripled federal spending to more than 10% of GDP. And by the time he died in
office, federal spending reached 44% of GDP â&#x20AC;&#x201C; an all-time high.
As everyone should know by now, the promises of socialism aren't affordable.
Robbing Peter to pay Paul is inefficient and kills Peter's incentives. The result is
usually economic stagnation, depression, and eventually a crisis that frees people
from the government's confiscatory repression. Because America was the only large
economy standing after War World II, it took much longer than usual for the
problems of socialism to appear in our economy. Also, the government scaled back
many of FDR's policies during the post-war boom. In winning the war, we also won a
generation of economic spoils.
All this changed in the 1960s. Lyndon Johnson had delusions of government-led
grandeur. His ideas of a "Great Society" and "Model Cities," along with an expensive
foreign war (Vietnam), were a recipe for massive new debts and an increasing role

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for government in all aspects of American life.
These policies led to an acute funding problem in 1971 because the debts of socialism
couldn't be financed with gold-backed money. It was far too expensive. And so we
began a new kind of socialism... the New American Socialism.
What happened in 1971? The size of America's government deficits forced us to
abandon gold. After World War II, the U.S. dollar became the world's reserve
currency. In exchange for placing the dollar at the center of the world's economy, we
made a solemn promise to always exchange the U.S. dollar for gold at $35 an ounce.
Nixon broke that promise, calling our creditors "global speculators" and telling them
to go pound sand.
This move away from gold severed the fundamental tie between our economy and
our money. Without the link to gold, bank reserves could be created by fiat. And they
were. This led to a huge expansion of our money supply and our debts.
The power to use this debt and to control the creation of new money is the most
powerful factor in our economy. The government can now create unlimited amounts
of credit to control the U.S. economy. This bestows favored status on certain
companies â&#x20AC;&#x201C; notably banks. This lies at the core of our economy's structure. It is how
fiat money privatizes the benefits of New American Socialism.
Most Americans simply don't understand our historic tie to gold made it impossible for
the banking system to grow beyond clear boundaries. Gold limited the amount of
currency in circulation, which, in turn, restricted how much money banks could lend.
Under the gold standard, the maximum total debt-to-GDP ratio was limited to around
150%. But as soon as we broke the tie to gold, our total debt-to-GDP ratio began to
grow. It's now close to 400%.
Without the tie to gold, the amount of economic mischief our government could
engineer became practically limitless. No social goal was too absurd... no war too
expensive... and no government insurance scheme too patently self-serving not to
finance.

Today, New American Socialism has spread like a cancer throughout our country,
afflicting industry after industry. Like a cancer, once it infects an industry, it
metastasizes from company to company in that sector. Suddenly, businesses cannot

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function without massive government aid. These corporate wards of the State weigh
down the rest of our economy... making us weaker and less competitive and dragging
us further into debt.
Keep in mind, this New American Socialism I'm talking about isn't called socialism at
all. It goes by many names. It's been called "compassionate conservatism." It's been
called "joint public-private enterprise." It's been called "government insurance."
I've been studying it for many years – finding it in one company after another. I've
actually preferred having it in many of the stocks I've recommended over the years
because it tends to be good for investors. That's the most insidious thing about New
American Socialism: It's a form of socialism that leaves the profit motive in place.
That's why the New American Socialism has grown decade after decade. That's why it
continues to be heavily promoted by almost every mainstream media outlet and both
political parties. It leads to a kind of corruption I believe will be impossible to stop
without a full-scale economic collapse.

Two Examples of New American Socialism
Look at the housing sector.
For decades, buying a house in America was a simple, private matter. If you wanted
to build or buy a house, you had to save up the money required or find private
financing. Private financing was hard to get because banks have trouble foreclosing
on real estate loans. Nobody wants to kick a delinquent borrower out of his house. As
a result, most banks would only lend half the money required to buy a home. They
also demanded their loan be repaid quickly – in no more than five years. That's why,
even at market peaks like 1929, mortgages only added up to 22% of the equity in
residential homes.
While this made housing difficult to obtain
for some people, it also prevented a credit
bubble that would sweep housing prices
higher. And because prices remained
constrained by what the real market (not
the debt-fueled market) would bear,
housing remained affordable.

For a fascinating history of the U.S.
mortgage market, I recommend you
read the 1961 report from the
National Bureau of Economic
Research titled "The Postwar
Residential Mortgage Market" by
Saul Klarman. It's out of print, but
you can find it online here.

In 1900, roughly 50% of Americans
owned their own homes. This suggests
homeownership was well within the reach
of most Americans, especially given the
fact that, in many crowded cities, home
ownership wasn't practical or desirable. This percentage – roughly 50% – remained
constant until the end of World War II when the government began creating more
ways for people to borrow money to buy homes.
These efforts went into overdrive when the government mortgage bank FDR created
as part of the New Deal was sold to private investors in 1968. Just think about this
for a moment... The government is using all its power to make loans available to
homebuyers, but the profits from these loans end up with individuals. That's New
American Socialism. The risks are socialized; the profits are privatized.
History is nothing if not ironic. In 1999, Franklin Delano Raines – named for the
former U.S. president – became the CEO of Fannie Mae, the government mortgage
bank. This FDR would blow up the housing bubble and set the stage for a massive
monetary crisis.

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Raines grew up in politics. He first wrote reports for President Nixon. Then, he
worked in the Carter administration. After that, he went to Wall Street and worked as
an investment banker for 11 years at Lazard. Then, it was back to D.C. to work for
Bill Clinton, who rewarded him with the top job at Fannie Mae. He was hailed as the
first black man to head a Fortune 500 company. Within five years, he'd resign in
shame... but not before setting the stage for the largest housing bubble in history.
Most of the crimes Raines committed while at Fannie Mae were paltry, petty graft. He
demanded illegal accounting changes that inflated the company's earnings. As a
result, he received huge amounts of fraudulent compensation â&#x20AC;&#x201C; around $20 million
per year. When his crimes were discovered, he resigned. Later, he agreed to a $3
million settlement with the government, which was paid by Fannie's insurance
company. He also gave up $1.8 million in stock and options (which were later worth
nothing in any case.) If you rob a bank, you go to jail. But if you steal $50
million-$100 million from the government's mortgage bank, you keep it all. That's
New American Socialism.
Raines was disgraced by his own enormous greed and lack of character. But those
crimes are merely an afterthought to the real damage he brought to our economy.
Raines was instrumental in building Fannie's mortgage portfolio to gargantuan
proportions. And he was responsible for the company's move into subprime loans.
Rather than lend money to homeowners, Fannie's strategy was to buy mortgages
from banks, which allowed them to banks to more homeowners. Fannie Mae also
guaranteed mortgage loans across the industry, which allowed more private capital to
become available. The theory was this made housing more affordable. It didn't. It
only allowed banks to make risk-free loans, which led to vastly higher home prices,
bigger banking profits, and huge profits for Fannie Mae at least temporarily. The
downside was the whole system was a charade... a giant con job. Fannie never had
the capital required to guarantee the loans it bought and insured. When the bubble
inevitably popped, the U.S. taxpayers ended up footing the $500 billion bill.
How could this have happened? How could the largest mortgage bank in the world be
run this way? Thanks to its close connection to the government, Fannie Mae didn't
have to submit annual reports to the SEC. It didn't have to meet the same capital
guidelines that applied to all of the other banks in the country. It could borrow almost
as much as it wanted. It could take almost any amount of risk it decided to take.
Again, how did that happen? How could Congress give such a huge organization a
get-out-of-jail-free card from the U.S. Treasury?
To maintain these incredibly lucrative advantages, Raines established Fannie Mae as
the largest lobbying organization in the United States. Fannie went so far as to set up
offices in key congressional districts. It began to control the elections of the
representatives it needed in Congress. And Raines helped pioneer the "Friends of
Mozilo" program (named for Angelo Mozilo, the disgraced former CEO of subprime
lender Countrywide Financial)... where key Washington officials got deeply
discounted mortgages for their personal properties. Raines reportedly received $3
million in loans from the program.
This is how New American Socialism works. Fannie Mae used the government to
establish a set of extremely valuable benefits in the market for mortgages. It used
donations to politicians to protect and extend these advantages. Fannie's executives
rode these advantages until the entire system collapsed. Then, they used the U.S.
Treasury to cover all of the losses, while the executives kept millions (or hundreds of
millions) in compensation.

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And what about the benefits for the rest of us?
We all ended up in debt. Some of us got lucky and made money on housing, but most
people got wiped out. The percentage of people who owned their own homes
increased from around 50% to more than 65% at the peak. But more often than not,
the cheap financing didn't allow people to buy a house. It allowed them to buy too
much house – a McMansion. Or it allowed them to buy too many houses. So today,
America has more empty houses than ever – roughly 10% of the entire housing
stock. People ended up with houses they didn't need and couldn't afford.
Worse... rather than making housing affordable... the exact opposite occurred. By the
peak of Fannie Mae's power in 2006, housing was the most unaffordable it had ever
been in America. It was totally out of reach for the median buyer – unless, of course,
that poor buyer was willing to take out an unaffordable mortgage. In that case, he
ended up losing his down payment and ruining his credit. And today, even after all of
that, he still doesn't have a house.
It was the only realistic outcome from such a harebrained, socialist experiment in
mortgage banking. It was ruinous for the middle class and the poor. And yet, it
enriched a tiny, elite group of Americans. It funneled colossal profits to Wall Street,
Washington, and certain favored homebuilders. What happened to the homebuilders?
They received tens of billions in "tax refunds" covering the five boom years of the
housing bubble to make up for the losses they suffered when the bubble burst.
In short, the rich kept all the money they'd made. And the poor got wiped out. That's
the new socialism model in a nutshell. Privatize the profits; Socialize the risks.

Socialism Today in America
Let me offer one more example. This tragedy is still brewing.
For many decades, the government has supported higher education in America. Does
the government give money to actual students based on their achievement? Yes...
but that's a small part of the program. Most of the government money spent comes
via access to student loans – so-called Title IV funding.
A host of rules apply to these loans, but knowing just a few of them is instructive.
The most important rule relates to a college's total revenue mix. To access Title IV
funding, a college cannot receive more than 90% of its revenue from governmentrelated sources. The government is allowing the market to determine whether or not
a college is useful and legitimate by requiring it to earn only 10% of its revenues
from private sources. (Does this sound smart to you? It's tantamount to requiring
only a tiny down payment to buy a house. It's dangerous because the student – and
the college – doesn't have much skin in the game.)
There's another important rule. Colleges can lose access to government-backed funds
if loans made to previous students experience default rates in excess of 25% for
three consecutive years. (Naturally, the rule has a key loophole, which I'll discuss in
a moment.)
These two key rules, which leave the government on the hook for 90% of the risk of
the student loans, led to the creation and massive growth of the for-profit education
industry. Clever entrepreneurs realized that a traditional college education wasn't
practical for many students who lacked either the cognitive ability to succeed at a
traditional college or the desire to acquire a liberal arts education. What many
students wanted, could master, and afford were essentially trade schools that taught
skills in demand from local employers. For-profit education grew up competing with
poorly funded community colleges. And they had a major advantage: huge marketing

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budgets.
Let me show you what this means in terms of how these for-profit schools spend the
Title IV money they receive.
Apollo is the largest company in the for-profit education space. In 2009, Apollo grew
its total revenues by $833 million. Yes, you read that correctly â&#x20AC;&#x201C; $833 million in
revenue growth during a severe recession. Its Title IV funding rose by $1.1 billion.
That is, the amount of government-related loans and grants it received increased by
more than its total revenue growth. The company became even more dependent on
the government.
Where did the money go? Not toward education. In 2009, Apollo increased its
spending on faculty and other instructional costs by $99 million. That is, out of every
dollar it got extra from the government it spent roughly 9Â˘ on actual education.
Instead, a lot of money went to shareholders. Since 2008, Apollo has spent more
than $1 billion buying back its own stock. But most of the money went to its
executives. Apollo currently spends almost $1.5 billion annually on compensation for
its administrators and salesmen.
In one way, you can argue for-profit education executives have earned their
paychecks. Enrollment is booming, with the public showing a clear preference for the
curriculum offered by the for-profit schools. Since 1986, enrollment in the sector has
grown sixfold. The U.S. now has 2,800 for-profit institutions of higher learning. About
10% of all college students are now enrolled in for-profit schools.
And you can make a good case these firms are providing a valuable service at a
reasonable price. Supporters of the industry note that average revenue per student
is the lowest at for-profit colleges: $11,130, while public universities average
$18,922 per student and private not-for-profit colleges received $37,869 per student.
So are these students (and our society) getting a bargain? Does foisting 90% of the
risk on government lead to positive outcomes? No, not really. Instead, much like
Fannie Mae did to housing, these government guarantees create huge incentives for
selling college to students who can't afford it. It also makes college more expensive
and less affordable.
The most recent examination of student-loan repayment shows for-profit education
students have much higher default rates. In 2008, the national default rate on
student loans was 7%. The default rate for private not-for-profit schools (the most
expensive) was 4%. The default rate for public not-for-profit school loans was 6%.
The default rate for private for-profit schools was 11.6%. U.S. Secretary of Education
Arne Duncan said of the numbers:
The data tells us that students attending for-profit schools are the most
likely to default... Far too many for-profit schools are saddling students
with debt that they cannot afford in exchange for degrees and certificates
they cannot use.
When you look at the default figures in aggregate, the problem jumps out at you.
Students at for-profit schools represent 26% of the borrower population. They make
up 43% of all defaults.
When I saw that number, the first thing that occurred to me was... "Wait a minute... I
thought schools get kicked out of the program if default rates reach 25% for three
consecutive years? How can for-profit schools represent so much of the default rate
when they make up so few of the students borrowing?"

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The answer is – borrowers who default after the first two years of repayment aren't
counted.
What?!?
That's right. To count as a default you have to stop repaying your student loans in
the first two years after graduation. The repayments required during this time frame
are extremely low – much like the teaser rate on a subprime mortgage. The real
extent of the problem can't be understood until you see the actual default rate on all
loans. After all, the real default rate isn't the percentage of students who default in
the first two years. It's the percentage of borrowers who never repay their debts.
What is the real number? Well, we don't know. The Department of Education won't
make that data public.
What we do know is the companies themselves write off between 50% and
60% of the private loans they make to their students.
The companies use these private loans to make sure they stay within the 90% rule
that governs access to the government's backing. That's tantamount to the many
second mortgages that were made on the side to homebuyers, so they could afford
their down payments. And not surprisingly, when folks buy a home using 100%
borrowed money or when they get a college degree using 100% borrowed money,
they frequently won't (or can't) pay the loan back.
I have no objection to a private lender who decides to lend to poor credit risks – even
for things like an expensive home or degree. But let that lender bear the risk. Don't
pass those risks to me via government protection.
Obviously, with 50% to 60% of these loans defaulting, the only real profit in the
system comes from the government's protection. And the scary part is the amount of
government money flooding into these schools is soaring.
Historically, little government money was available to these schools – only $2 billion
to $4 billion a year. But then... with the right kind of legal corruption... the
floodgates opened.
Sally Stroup was the head lobbyist for Apollo. In 2002, she became the assistant
secretary of the Department of Education under President Bush. Guess what
happened next?
Stroup gutted the rules that governed which students these schools could recruit.
Government funding for for-profit college education is now more than $20 billion a
year. And at current growth rates, within 10 years 40% of all government-backed
college funding will go to for-profit education.
Call it socialism. Call it New Socialism. Call it compassionate conservatism. It doesn't
matter what you call it, the rules of the game are clear: The government takes all of
the risk while investors and executives keep all of the profits.
This industry is selling a product its customers cannot afford. This industry
overwhelmingly targets women and minorities – people who are often up against a
wall financially. This industry games the rules of the government and spends a
fortune on lobbying – more than $12 million in the last year. This industry would
literally not exist without government-guarantees standing behind 90% of its
revenues. And Wall Street experts estimate this industry will rack up around
$250 billion in credit losses over the next decade – an amount of money that
exceeds the losses from Fannie Mae and Freddie Mac so far.

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All of these risks will eventually cost the U.S. Treasury billions, as these students will
never be able to repay these debts. While these students have no financial skin in
the game (many borrow 100% of their tuition), they face enormous consequences
down the road from this scheme... Student loans are notoriously difficult to
discharge, and many borrowers will be crippled financially by the obligations they
cannot afford.
The facts of this situation are incontrovertible and well known – even inside the
current president's administration. And yet... and yet... even when all of these facts
were studied and reviewed... what did the president do?
Critics had demanded so-called "gainful employment" regulations that would limit
how much a student could borrow to an amount of money he would likely be able to
repay based on the current employment and income track record of other alumni.
Obviously, such sensible regulation was never likely to be implemented by
Washington... especially not by a minority president when the funding in question
goes overwhelmingly to poor, minority students.
Instead, in early June, Obama's administration promulgated a new set of rules that
were supposed to address the abuses and the risks of the government's 90%-funding
rules for for-profit education.
The new rules actually loosen the funding requirements – substantially. Colleges will
be eligible for federal support as long as at least 35% of their students are repaying
their loans over the first three years. Now, up to 65% of the students can default.
And what about limiting loan amounts to ability to repay? Loan amounts may not
exceed 30% of anticipated discretionary income. How will students pay for food,
housing, transportation, insurance, etc. if they're spending 30% of their incomes on
student loans?
Rather than tightening the standards, the new rules actually loosen the standards.
They also go further in guaranteeing continued federal support. Under the new rules,
no schools will lose funding until 2015 at the soonest, to give them time to adapt to
the new "standards," which were trumpeted as a major reform.
Only in Washington D.C.

The Investment Challenge
I have a question for you, dear subscriber. It's a complicated one though... so bear
with me.
The for-profit education "business" is one of the most obvious frauds ever foisted on
the American people. The industry has been structured to take advantage of the least
sophisticated members of society. It promises benefits the students on average are
unlikely to achieve: a better job and a better life. Instead, they are saddled with
unpayable debts and enjoy no corresponding increase in wages.
Assuming the government should not do anything to protect the students from this
fraud, shouldn't the risks of perpetrating this fraud be left with the companies
themselves? Let Apollo guarantee these loans. Let it take the risk that these debts
will never be repaid.
But that's not how the New American Socialism works. What happens is, all of the
profits of this scam go to the executives and the shareholders. The risk – 90% of it –
goes to the government.
Socialism always destroys the poor because it robs them of social mobility and makes

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it impossible to protect themselves from the predations of the powerful. Historically,
its damage has been limited because eventually socialism so disrupts an economy
that even the rich and the powerful suffer. That's what's so dangerous about this New
American Socialism. It doesn't subject the rich to any depravation at all. It does just
the opposite. The New American Socialism retains the profit motive for the rich and
the well connected. In this new model, only the poor suffer. The rich are always
protected.
It's capitalism for the rich, without any risks. And socialism for the poor,
without any rights.
My question to you is, what's the future of our country? Our leaders are now so
corrupted by New American Socialism they can't even stop the for-profit education
scheme I describe above. The facts, by the way, aren't even in dispute. This is the
obvious stuff – the stuff no one can really dispute. If our leaders let this industry rack
up $250 billion in bad debts over the next decade, how can we expect them to do
anything to stop our massive annual deficits and our runaway federal debt? If the
administration can't stop the for-profit education industry from getting its hands into
the U.S. Treasury, whom will it stop? Nobody.
The entire system is so corrupt investors must begin to view U.S. government bonds
and our currency with great suspicion.
As investors, the hard question is, how should we handle companies and sectors
caught up in the forces of New American Socialism? Should we buy shares of Apollo
(Nasdaq: APOL)? They're cheap, trading at about 3.5 times cash earnings, and the
U.S. Treasury has essentially guaranteed its future revenues. That's certainly
attractive. My bet is the stock doubles over the next year.
But... are you willing to make a profit on a business that couldn't survive without
government protection, whose products probably aren't saleable in a real market?
How mercenary are you? It's a difficult question.
Despite my misgivings about the business model, given the government's recent
decision to continue providing loans to Apollo students it's probably a good stock to
own. The only real question is: Do I want to be buying stocks – any stocks – right
now? For me, the answer is no.
The problem is, the system itself is unstable and unsustainable. We can't know when
or how, it will break down. But we know it can't last long. Why not?
Consider the big problem brewing in U.S. pension funds. If pension funds can't meet
their obligations, the federal Pension Benefits Guarantee Corporation (PBGC) must,
by law, assume the obligations.
I would like to nominate the PBGC as the most Orwellian of all government agency
names. You see, the PBGC is not a corporation at all. It is a federal agency. And it
doesn't really guarantee anything. It's just another phony insurance scheme, where
the disbursements were supposedly going to be funded by premiums paid for by
private industry. But in fact, according to research conducted by The New York
Federal Reserve, the PBGC is already underfunded by at least $30 billion.
I believe even that large sum is probably optimistic.
U.S. pension funds currently control roughly $15 trillion in assets. That's, by far, the
largest pot of institutional money in the U.S. (or the world). It's bigger than mutual
funds. It's bigger than insurance companies. It's much, much bigger than hedge funds
or private-equity funds.

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And here's the big problem... Almost all pension funds assume an 8% annualized
return over the long term. The actual performance for the last decade has been much
worse – basically flat. If you change the assumptions behind pension fund accounting
to adjust for a world of low interest rates and smaller average returns – say to a 5%
annualized return – suddenly, pension funds are not underfunded by 20% on
average, they're underfunded by 40% on average, according to the research done by
my friend Mebane Faber at Cambria Capital. That implies future unfunded pension
obligations of $3 trillion to $5 trillion.
I believe the health of our pension funds reflects the real health of our economy.
When the largest pots of institutional money can't meet their obligations, your
economy is suffering a dramatic and dynamic problem.
The problem is New American Socialism. It's that government spending (and
government power) has so warped our economy that little gets done without a
government racket/protection scheme in place. Quite simply, our country has bought
into the idea that it's OK to rob Peter to pay Paul, as long as the profits in the
transaction go towards certain well-connected corporations, lobbyists, and
congressmen.
The New American Socialism is perfect for a society that's organized by special
interest groups and believes its economic power is eternal. After all, the entire
structure is fueled by debt that individuals inside the system believe someone else
will have to repay. The New American Socialism is founded on an institutionalized
belief, across our country, that Vice President Dick Cheney had it right: Deficits don't
matter. As a result, debt continues to grow faster than it can even be accurately
counted.
Sooner or later, these debts will bankrupt all of us. The only question is when. Maybe
sooner than anyone realizes. There's about to be a major crisis in the high-yield
sector of the credit markets.
In fact, it has already begun.

Another Crisis in Credit
Last week, at the annual New York meeting of the private wealth club I founded,
Atlas 400, one of our members stood up. He is a senior executive at a major Wall
Street bank. He is in charge of the bank's high-yield, fixed-income desk. He is one of
the world's leading dealers of high-yield bonds. He told our group he wouldn't buy
anything in the space, and at some point in the next few months, he predicted the
market would endure a complete wipeout. He said the market began to turn last
week, and deals were getting harder and harder to price.
The market is blaming the "back up" in high-yield bonds on the Federal Reserve,
which has been selling some of the assets it took over in its bailout of AIG. It has
dumped roughly $30 billion of these so-called Maiden Lane II securities onto the
market over the last month. (These are mostly lower-quality mortgage securities.)
This influx created a big increase in the spread between high-quality debt and
high-yield debt. You can see the impact on the market in this chart of the Dreyfus
High Yield Strategies closed-end mutual fund, which is simply an investment fund of
high-yield bonds:

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The Fed selling $2 billion-$3 billion per week of Maiden Lane II was enough to make
the credit market tank last week. Imagine what will happen on June 30, when the
Fed ends its $600 billion quantitative easing program. The Fed has been printing
money and buying roughly $85 billion worth of Treasury bonds per month. That gives
the credit market a huge boost. The capital that otherwise would have filled the U.S.
Treasury coffers has instead been available to buy higher-yielding debt.
When quantitative easing stops, the high-yield market will continue to fall â&#x20AC;&#x201C; forcing
credit spreads wider. This will make low-quality bonds harder to sell, reduce the
amount of credit available to the U.S. economy, and cause a pull back in the markets.
You can think about it this way... adding just $2 billion a week to supply caused the
credit market to catch a cold. Imagine what will happen when $20 billion a week is
withdrawn from demand.
To anticipate this looming event, I'd like us to return to some of our favorite short
positions from the previous crisis period â&#x20AC;&#x201C; Capital One Financial (NYSE: COF) and
General Electric (NYSE: GE). Both of these companies rely on the credit markets.
You can see that by looking at a short-term chart of their stocks as compared to the
movement in Dreyfus High Yield fund:

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Capital One owns a large portfolio of unsecured credit-card debt. Additionally, as
cardholders continue to increase their balances, Capital One must securitize these
obligations. If credit spreads widen, Capital One will make less money going forward
as investors will pay lower prices for its loan securities and investors may well begin
to doubt the value of its assets.
Capital One's business is huge and has been performing well lately, thanks to fat
margins made possible by low funding costs – aka the Fed's near-zero interest rate
policy. The company holds $124 billion of credit-card debt, funded via $109 billion of
low cost deposits. It makes more than 7% currently on the spread between what it
earns from the credit card receivables and what it pays for the deposits.
My bet is that Capital One's funding costs will increase and the value of its credit-card
receivables will decline because of increased financial stress related to a slowing
economy.
We made a similar prediction in 2008, and we were right. In the recession of 2009,
Capital One's charge-off rate reached 10%. Currently, its allowance for loan losses is
near 4%.
However, selling Capital One short is risky. If credit spreads don't continue to widen
and if the company's charge-off rate doesn't increase, the Fed's zero-percent interest
policy will continue to make this a profitable business.
So while I recommend taking this short position ahead of the end of QE2 on
June 30, I advise you to use a 15% stop loss initially on the position. This will
protect us against getting the timing wrong on this short. Also, I would remind you to
use a sensible position size on this position. No more than 4% of your portfolio. This
short sell recommendation, as with most of my short sell recommendations, is a
hedge. Our expected return on these kinds of positions is breakeven, on average.
Shorting stocks in the market protects us in the event of a widespread downward
move in the market.
As you know, we haven't shorted many stocks, despite being fundamentally bearish
since February 2010. It is difficult to make money shorting stocks when the Federal
Reserve has a printing press that's spitting out the world's reserve currency. I am
returning to a more active shorting position because I believe the end of QE2 will
reveal the financial world more accurately... as the tide goes out, more financial
institutions will be revealed as being far weaker than is commonly believed.
Nowhere else is that more true than with General Electric.
The numbers on this company – America's leading company – are simply astounding.
Even though GE has paid down $80 billion in debt over the last two years, it still
owes its creditors more than $600 billion. This is an amazing figure. It is more money
than Greece owes its foreign creditors. It's more money than Portugal owes. It's
larger than the entire external debt of Brazil... and Turkey... and Mexico. It's five
times as much money as notorious Iceland owes.
Defenders of GE will surely explain that this $600 billion figure is something of an
exaggeration because the company holds so many safe assets – it has $468 billion in
investments and cash. The problem is, many of these investments are credit-card
receivables and dicey mortgages in Eastern Europe.
Why is one of America's largest and most important corporations heavily invested in
credit cards and Eastern European mortgages? New American Socialism. Investing in
risky, high-yield financial instruments allows the company to maximize its credit
rating and its political connections to produce the largest possible profits. But this

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business model is incredibly risky. In fact, GE would have gone bankrupt in 2008
without the aid of the U.S. government, which has guaranteed all of the company's
debts through 2012 – for free.
And... what did the politicians decide to do about GE in the wake of the financial
crisis? Nothing.
In spring 2010, the government began efforts to reform the banking sector, hoping to
prevent a repeat of the 2008 crisis. The bill, ironically, is known as Dodd-Frank –
ironic because Sen. Dodd and congressman Frank were the two primary recipients of
Fannie Mae's lobbying efforts over many years. And Dodd was a beneficiary of the
notorious "Friends of Mozilo" loan scheme.
Part of the reform – known as the Volcker Rule – forbids large financial firms from
owning hedge funds and increases regulations on their derivative trading. But these
rules only apply to companies "predominantly engaged" in financial services, defined
as companies where 85% of annual revenues or consolidated assets come from
financial activities. At GE, 83% of its assets are finance-related.
In other words, one of the largest financial companies in the world is not governed by
the Volker rule. The financial reform act didn't reform GE, whose potential
bankruptcy would have dwarfed the losses at AIG, Bear Stearns, and Lehman
Brothers.
Only in America.
If you've followed my work on GE over the last few years, you know my argument
against the company. It grew its balance sheet by enormous proportions, increasing it
roughly $200 billion, during the credit bubble of 2003-2008. To pay back its huge
debt load, it is selling assets. That's the good news.
The bad news is, selling its best assets (like half of NBC Universal) increases the size
of its distressed assets as a percentage of its total assets. So while total debts are
down, I would argue the real leverage in the portfolio is up. GE has fewer
high-quality assets to support the debt. And you can see this by looking at cash
flows.
In 2008, with $797 billion of assets, GE produced $48 billion in cash from operations
– a cash return on assets of 6%. In 2009, with an asset base of $781 billion, the
company produced $24 billion in cash. A cash return on assets of only 3%. And in
2010, with an asset base of $751 billion, the company produced cash from operations
of $36 billion, a cash return on assets of 4.7%.
My point is, even though GE has recovered somewhat from the recession of 2009, its
return on assets has not rebounded to pre-crisis levels – not even close.
And consider this...
In 2010, with cash from operations at $36 million, GE decided to repay $49 billion in
debt. That's good. It funded this debt reduction by cashing in investments that
produced $42 billion in cash. That's fine, too – except these huge profits are not
repeatable. In any case, GE produced a total of roughly $68 billion in free cash flow
in 2010. It chose to spend almost $50 billion of that in debt repayment, leaving
roughly $18 billion. Then it paid a $5 billion dividend and spent $4 billion on share
buybacks.
Why would a company that's so far in the hole spend almost $10 billion on capital
distributions to shareholders? Right now, if GE put 100% of its cash from operations

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into debt repayment every year and its earnings stayed at 2010 levels, it would take
16 years to pay off its debts. It would take at least a decade to pay down its debts to
a more manageable level. No question, if GE were being managed prudently, that's
what it would do.
GE holds about $40 billion in tangible equity. I believe its European mortgage losses
are likely to be at least this large over the next five years, which means, at some
point soon, GE could be going to the market for new equity. If that happens, the
company's share price will probably fall in half.
Why run the company this way? Because the managers know GE is too big to fail.
They're not running the company as though they actually own it. They're simply
running it to maximize their own compensation. If it fails, it fails. The stockholders
will get wiped out and the government will bail out the creditors. In the meantime,
GE's managers are trying to get rich. They want to keep the company as leveraged as
possible. They don't want to repay debts. They want to maximize the company's
ability to borrow.
That's how New American Socialism works. We're not building a better tomorrow.
We're building a better today.
I'm willing to bet it doesn't work out like most people expect. Instead, I think the
folks running GE are going to get what they deserve... and sooner than they realize.
I recommend shorting shares of General Electric (NYSE: GE). Use a 25%
trailing stop.

SIA Indicator
As you can see in the charts below, our indicators remain neutral, with a somewhat
bearish bias. Specifically, only eight companies now make our "black list." The small
correction we've seen in stock prices since about mid-March has taken some of the
froth off of the equity market â&#x20AC;&#x201C; but not all of it.
SIA Black List: Down to 8

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SYMBOL

SHORT NAME

MARKET
CAP

PRICE-TOSALES

BIDU US Equity

BAIDU INC-SP ADR

43,499,347,968

31.12

VMW US Equity

VMWARE INC-CL A

39,813,808,128

12.79

PSA US Equity

PUBLIC STORAGE

20,033,110,016

11.34

CRM US Equity

SALESFORCE.COM

18,829,019,136

10.37

IVN CN Equity

IVANHOE MINES

14,946,920,448

161.03

AVB US Equity

AVALONBAY
COMMUN

11,583,410,176

12.32

SLW CN Equity

SILVER WHEATON

10,745,690,112

22.04

YNDX US Equity

YANDEX NV-A

10,151,419,904

21.57

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Our money-flow gauge shows that we're a long way from a buying opportunity, as
mutual funds continue to buy stocks.
Please pay attention to the SIA Spread Signal Chart this month and for the next
several issues, as I expect this is where the "action" will be. I think we are going to
see spreads continue to move higher, which will produce a correction in the stock
market. If the Fed doesn't produce another round of quantitative easing, this could
lead to a new credit crisis. The fact is, the U.S. economy is far too indebted. And the
ongoing sovereign crisis means that, sooner or later, we'll face another credit crisis.

Portfolio Review
This month, we're making a lot of adjustments â&#x20AC;&#x201C; moving the portfolio into a better
bear-market position.
As I wrote in an e-mail last week, we want to lighten up some of our commodityrelated positions. Sell Titanium Metals (NYSE: TIE) and Arch Coal (NYSE: ACI)
now, if you haven't done so already.
Likewise, we recommend selling Posco (NYSE: PKX), the Korean steel giant, which
briefly traded for less than our $100 recommended buy limit late last week. We have

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also moved our entire long portfolio to a "hold." In general, we do not want to buy
stocks in the face of the next round of the credit crisis.
Good investing,
Porter Stansberry
June 16, 2011

* This is the return since reference date, including dividends.
Stansberry's Investment Advisory's Model Portfolio does not represent any actual investment result. Our reference
price represents the price of our recommended securities at the time we wrote the recommendation. Our sell price
represents the closing price at the time a reasonable reader would have had the opportunity to sell, typically the
day after such a recommendation is given.
Please note: Our investment philosophy requires limiting risk through the use of trailing stop losses. Unless
otherwise noted, all recommendations use a 25% TRAILING STOP LOSS. NEVER ENTER YOUR STOPS INTO
THE MARKET. KEEP SUCH INFORMATION PRIVATE.
How to use a trailing stop: A stop loss is a predetermined price at which you will sell a stock in case it declines. A
"trailing stop" is a stop loss that "trails" a stock as it rises. For example, let's say you set a 25% trailing stop on a
stock you purchase for $10. If the stock rises to $20, you would move your trailing stop to $15 ($5 is 25% of
$20, $20 - $5 is $15). Only use closing prices, and never enter your stop into the market. For more information,
see our frequently asked questions at www.stansberryresearch.com/secure/faq.asp.
Our risk label is based on current share price and one-year business outlook. 1 = the lowest possible risk. 10 = the
highest possible risk.

Corrections Regarding Last Month's Portfolio Page

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There were two unfortunate mistakes in last month's portfolio update. First, we
announced we hit a trailing stop loss on Silver Wheaton when, in fact, we had not.
We alerted everyone about the mistake immediately via an e-mail update.
Unfortunately, another mistake was subsequently discovered. Our Pulte short hit a
trailing stop loss at $8.24 in late April, which we simply missed because it barely
closed above our stop. We hope you, like us, missed the stop and that you continue
to hold the position short. We have decided to leave Pulte in our portfolio. That's sure
to give our critics a lot of ammunition. So we'll admit upfront it's cheating. It is also
true that our long-standing advice has been to sell the stock short above $8. If you
did close the short, feel free to sell Pulte short again whenever it trades for more
than $8. From now on, we'll place a hard $10 stop loss on the position. We will only
sell if shares trade for more than $10. Fundamentally, we remain more convinced
than ever that the stock will ultimately fall to zero. We've taken concrete steps to
ensure these mistakes don't happen again.
Published by Stansberry & Associates Investment Research.
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ÂŠ 2011 Stansberry & Associates Investment Research. All rights reserved. Any reproduction, copying, or redistribution,
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Baltimore, MD 21202 or www.stansberryresearch.com.
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